Securities Fraud Flashcards
Churning
Churning is the excessive trading of a customer account to generate commissions while disregarding the customer’s interests. Specifically, churning occurs when an investment professional excessively trades an account for the purpose of increasing his commissions instead of furthering the customer’s investment goals.
Front running
Front running is a type of insider trading. Front running involves the use of the privileged knowledge of a customer’s order to buy or sell a large amount of a commodity, option, or security that, because of its size, is likely to move the market.
The Commodities Futures Trading Commission (CFTC),
The Commodities Futures Trading Commission (CFTC), which can be described as the SEC’s counterpart for the futures and commodities industry, regulates the activities of futures commission merchants (FCMs) and their associated persons.
What is a security
The default definition of security is the term investment contract. In the case of SEC v. Howey Co., the Supreme Court established a four-step test for an investment contract. The test, which is known as the Howey test, states that a financial instrument is an investment contract if the following four elements are met:
• There is an investment of money or other asset.
• The investment is in a common enterprise.
• There are expectations of making a profit.
• The profits are to be derived solely from the efforts of someone other than the investor.
limited partnership
A limited partnership is similar to a general partnership, except that in addition to one or more general partners, limited partnerships also have one or more limited partners. In contrast to a general partner, who has unlimited personal liability, a limited partner is a passive investor whose liability is limited to the amount of his investment in the company. Thus, in a limited partnership, the general partners manage the enterprise’s activities, and the limited partners supply the funding. Limited partners do not manage the enterprise’s activities.
Unlike general partnership interests, interests in limited partnerships are generally held to be securities because this type of structure conforms closely to the definition of an investment contract.
To determine security marteriality
Securities laws require that the investor receive full and fair disclosure of all material information, and they make it unlawful for anyone to obtain money or property by using a material misstatement or omission in the offer or sale of any securities.
As a general rule, to determine materiality, the fraud examiner needs to answer the following question: “Would a reasonable investor wish to know this information to make an informed decision?” If the answer is “yes,” then this information, or the lack thereof, has a high likelihood of being deemed material. (If an actual investor acted based on the misrepresentation, that clearly strengthens the case, but it is not essential that the false or misleading statement influenced an investor, merely that a reasonable investor could have been so influenced.)
Uniform Securities Act of 2002
The Uniform Securities Act of 2002 provides that, unless certain exemptions apply, a security cannot be sold or offered for sale until all of the following requirements are satisfied:
• There is a registration in place to cover the security.
• The securities professional is registered.
• There is full and fair disclosure of all material information.
What are the rules relating to suitability for security broker-dealers in recommending investments:
Securities broker-dealers are prohibited from recommending investments or investment strategies that are unsuitable for their clients. Thus, making unsuitable recommendations (e.g., recommending high-risk options to a senior citizen with limited assets) is prohibited.
Essentially, there are two rules relating to suitability: the “know your customer” rule and the suitability rule. The “know your customer” rule provides that securities broker-dealers must know their customer financially to effectively service the customer’s account and to minimize the risk of recommending an inappropriate investment. Thus, this form of suitability violation occurs when a broker recommends an investment or investment strategy to a client without having conducted due diligence to ascertain relevant personal and financial information about the client.
In addition to the “know your customer” requirement, there are suitability requirements that broker-dealers must follow when making recommendations to a client. The suitability rule prohibits a broker-dealer from making a recommendation to a client if the broker does not have reasonable grounds for believing that the recommendation is suitable for the client. This form of suitability violation occurs when a broker recommends an investment, recommends an investment strategy, or makes an investment that is inconsistent with the client’s objectives, and the broker knows or should know the investment is inappropriate.
Securities Act of 1933
The Securities Act of 1933 created interstate registration requirements, providing that it is unlawful to sell or offer to buy or sell a security unless a registration statement has been filed with the SEC. The registration filing, however, will not prohibit the offer or sale of a security if the transaction is exempt or the security being sold is exempt. Therefore, if a security qualifies for an exemption, it can be offered to the public without being registered with the SEC. Both federal and state laws provide for exemptions.
SEC Rule 10b-5
Rule 10b-5—which the SEC promulgated pursuant to Section 10 of the Exchange Act—prohibits false statements and other fraudulent activity in connection with the purchase or sale of any security. Rule 10b-5 is often referred to as the Act’s anti-fraud provision.
Specifically, Rule 10b-5 states that: “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,
• To employ any device, scheme, or artifice to defraud,
• To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
• To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”
Securities Exchange Act of 1934
Investment Fraud Prevention Act of 1933
Like Securities Act of 1933, Congress enacted the Securities Exchange Act of 1934 due to concerns over the 1929 stock market crash and the manipulation of the securities markets, but unlike the 1933 Act, the Securities Exchange Act of 1934 mainly deals with post-issuance trading. Simply put, the 1933 Act regulates the issuance of the securities themselves, and the 1934 Act covers subsequent trading of securities through brokers and exchanges.
